Download Deficits, Debt, and Interest

Deficits, Debt, and Interest
“
When the government
runs a deficit, it
increases the national
debt; when the
government runs a
surplus, it shrinks the
debt.”
Updated February 12, 2016
Three important budget concepts — deficits (or surpluses), debt, and
interest — are often misunderstood.
Deficits (or Surpluses)
For any given year, the federal budget deficit is the amount of money the
federal government spends (also known as outlays) minus the amount of
money it takes in (also known as revenues). If the government takes in
more money than it spends in a given year, the result is a surplus rather
than a deficit. The 2015 budget deficit was $438 billion (2.5 percent of
gross domestic product, or GDP) — down significantly from levels it
reached in the Great Recession and its immediate aftermath.
When the economy is weak, people’s incomes decline, so the
government collects less in tax revenues and spends more for safety net
programs such as unemployment insurance. This is one reason why the
deficit typically grows (or a surplus shrinks) during recessions.
Conversely, when the economy is strong, the deficit tends to shrink (or a
surplus grows).
Recessions aren’t the only causes of deficits. A government may also
face a structural deficit, or one that would exist even if the economy
were operating at full capacity, with high employment.
Economists generally believe that increases in the deficit resulting from
an economic downturn perform a beneficial “automatic stabilizing” role,
helping moderate the downturn’s severity by cushioning the decline in
overall demand. In contrast, when the government runs structural
deficits and borrows large amounts of money even in good economic
times, that borrowing is much more likely to have harmful effects on
private credit markets and hurt economic growth over the long term.
Debt
Unlike the deficit, which drives the amount of money the government has
to borrow in any single year, the national debt is the cumulative amount
of money the government has had to borrow throughout our nation’s
history. When the government runs a deficit, it increases the national
debt; when the government runs a surplus, it shrinks the debt.
There are two common measures of the national debt:
 Debt held by the public (sometimes called net debt) measures the
government’s borrowing from the private sector (including banks and
investors) and foreign governments. At the end of 2015, debt held by
the public was $13.1 trillion.
 Gross debt is debt held by the public plus the securities the Treasury
issues to U.S. government trust funds — that is, money that one part
of the government lends to another. For example, each year Social
Security takes in more money in payroll taxes and other income than
it distributes in benefits; the amounts not needed to pay current
benefits are invested in Treasury bonds and the Treasury uses the
proceeds to help pay for government operations. As a result, the
Treasury owes money to the Social Security trust fund and will repay it
when Social Security needs the money to pay future benefits. At the
end of 2015, Social Security, Medicare, and other trust funds held
$5.0 trillion of Treasury securities, bringing gross debt to $18.1
trillion.
Debt held by the public is a far better measure of debt’s effect on the
economy because it reflects the demands that the government is placing
on private credit markets. (When the Treasury issues bonds to Social
Security and other trust funds, by contrast, that internal transaction does
not affect the credit markets.)
The chart above shows deficits and debt relative to the size of the
economy (as measured by GDP). The budget does not have to be
balanced to reduce the economic burden of the debt. For example, even
though there were deficits in almost every year between World War II and
the early 1970s, debt grew much more slowly than the economy, so the
debt-to-GDP ratio fell dramatically.
Debt held by the public was 74 percent of GDP in 2015. That ratio is
more than double what it was in 2007, with the jump largely resulting
from the Great Recession and efforts to mitigate its impact. Under
current budgetary policies, the debt-to-GDP ratio is expected to rise
about 10 percentage points over the coming decade and continue rising
over the subsequent decades as well. The ratio is currently high by
“
Economists generally
believe that increases in
the deficit resulting from
an economic downturn
. . . help moderate the
downturn’s severity by
cushioning the decline in
overall demand.”
“
Raising the debt limit . . .
allows the government
to pay for spending on
programs and services
that Congress has
already approved.”
historical standards, leading some policymakers and analysts to call for
more deficit reduction in order to lower the debt ratio. While economists
generally believe that the debt-to-GDP ratio should be stable or declining
when the economy is strong, too much deficit reduction too fast is
harmful to an economy that is not at full strength.
Interest
Interest, the fee a lender charges a borrower for the use of the lender’s
money, is the cost of government borrowing. Interest costs are
determined by both the amount of money borrowed (also known as the
principal) and the interest rate. When interest rates rise or fall, interest
costs generally follow, making the national debt a bigger or smaller drain
on the budget.
In 2015 the federal government incurred $223 billion in net
interest. Federal net interest costs, which have been held down by very
low interest rates in the Great Recession and its aftermath, amounted to
1.3 percent of GDP and 6.1 percent of government spending in
2015. Both of these figures are near their lowest levels over the last 50
years. But interest costs — in dollar terms, as a percent of GDP, and as a
share of the budget — will increase as debt continues to grow and
interest rates return to more normal levels.
The Debt Limit
Congress exercises its constitutional power over federal borrowing by
imposing a legal limit on the amount of money that the federal
government can borrow to finance its operations. The debt subject to
that limit differs only slightly from the gross debt. Thus, it combines debt
held by the public with the Treasury securities held by U.S. government
trust funds.
Once the debt limit is reached, the government must raise the debt limit
or default on its legal obligation to pay its bills. Congress has raised the
debt limit more than 90 times since 1940.
Raising the debt limit does not directly alter the amount of federal
borrowing or spending going forward. Rather, it allows the government
to pay for spending on programs and services that Congress has already
approved.
Nor is the need to raise the debt limit a reliable indicator of the
soundness of budget policy. For example, Congress had to raise the
debt limit a number of times between the end of World War II and the
mid-1970s, even though the debt-to-GDP ratio fell significantly over this
period. Similarly, debt subject to limit rose in the late 1990s — even
though the budget was in surplus and debt held by the public was
shrinking — because Social Security was also running large surpluses
and lending them to the Treasury.